I am writing this just before the NY open of US markets. And we have the makings of serious losses on the back of an absolute pounding in the cryptocurrency space. There, the largest asset, Bitcoin, has been cut in half with most of the losses coming in the last 24 hours. I think this is all related to the convulsions of the reflation narrative ending and is a classic buy the rumour sell the news situation. Some thoughts below
Economic growth deceleration
The bloom has come off the rose. I am not talking about Bitcoin or Dogecoin here – though I could be by proxy. I am talking about the reflation trade, the concept that upon a full re-opening, a wave of pent-up demand would buoy the US economy and other economies indefinitely, eliminating the need for government largesse to sustain economic momentum.
That was the ‘rumour’ that buoyed markets early in 2021 as vaccines rolled out and GDP growth in the US surged on the back of government transfers. But now we are about to get the ‘news’. It’s the real thing. And either we meet and beat expectations or we don’t.
For the time being, we are not meeting and beating expectations. Economic data show economic growth potentially decelerating from a peak in Q1 and early Q2 to a less robust level just as the peak of US federal spending is poised to wane and state governments are cutting off pandemic-related unemployment transfer payments. That’s not a good look. And I believe it is negatively affecting sentiment.
Let me give you a few examples. It’s not just the consumer price inflation reading and the jobs numbers from last week, though those are the biggies. It’s also housing starts and building permits that were below expectations on Tuesday. And what the uneven data point to is the possibility that people got carried away with the whole pent-up demand thinking, a classic buy the rumour sell the news setup.
Animal Spirits
What I believe has happened is this. Back in April, I wrote a post called “The ‘interregnum’ of risks to the upside as yields turn down“. The thesis there was that the full-on reflation narrative was associated with bond yields going up and the yield curve steepening. This got stopped out at just above the 1.75% level on the US 10-Year, with Q1 the worst quarter for Treasuries in four decades. We then entered an interregnum – a ‘free pass’ period during which time the data didn’t matter until people knew what the full re-opening period looked like.
I summarized my view this way:
So, for the time being, I am looking at the present phase a ‘free pass’ period, where the data don’t really matter. Only momentum matters. And I believe we can sustain this interregnum period up through the start of summer, by which time the US will be nearly fully re-open and inflation comparisons to 2020 will be meaningfully absent of lockdown-associated disruption.
The key part of that paragraph is the sentence “Only momentum matters.” We can sustain the interregnum just so long as people are satisfied that the reflation narrative was correct, both in direction and magnitude. To the degree jitters set in about this narrative, momentum will take us in the wrong direction. And clearly the recent data prints have created jitters.
I would argue the jitters haven’t completely set in. But, if the data disappoint enough, they will. And animal spirits will take us down, making this a classic ‘sell in May and go away’ summer.
The bubble
But, let me also address the bubble here as well. Just a re-iteration of “A quick word on bond vigilantism and market mania“:
There’s a mania, a bubble, happening right now in financial markets with crypto. Coinbase, the newly public crypto exchange, has a market capitalization of $67 billion. That’s about the same as Intercontinental Exchange, which owns the New York Stock Exchange, among other things. This is absurd. It’s emblematic of the mania surrounding us, because valuations are more and more representative of what the market will bear, what the greater fool will pay for a financial asset, and less of the underlying value of that asset.
People are saying, “we’re in a new era” because the policy paradigm has shifted so dramatically. They think that, when bad things happen, policymakers will have their back. And so, it’s fine that fundamentals don’t matter.
But this is a phase. And this phase will end. And it will end with a pop, not a fizzle.
What’s happening with Crypto right now is emblematic of what I wrote. Make no mistake, there is a bubble happening in the cryptocurrency realm. And despite all of the HODLers telling you this is a normal correction right now, we do have to consider that it is a bubble popping, with massive losses all around.
We are now in a position where the most speculative assets don’t need rates going up for them to implode on their own weight. And that’s a sign that momentum has indeed shifted. Does that momentum shift for the market as a whole? Let’s see. I continue to believe the data will have a key role to play. But, animal spirits can take over and spill over from the speculative markets into the broad markets in a hurry.
My View
Let me remind you what I said last week:
I would argue the risk has shifted again from upside risk, back to downside risk. The overshoot on inflation and undershoot on employment in the US tells you that. Moreover, equities are still very much vulnerable to discounted cash flow valuations. Don’t believe it when people tell you otherwise. This is still the only reliable way we have of thinking of valuation – future cash flows discounted back at some rate to present value terms.
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However you look at it though, the Coming to Jesus moment for inflationistas and pent-up demanders alike is right around the corner. And so, the full re-opening will usher in a much better understanding of where we’re headed. There are likely to be serious surprises in asset market valuations.
I think what we are seeing – the jitters in the speculative corners of the market – are a reflection of reality settling in again. The price action in speculative assets and the market as a whole became unsustainable except in the rosiest of scenarios. And with the full-reopening upon us, we are beginning to see that things are not as rosy as we want them to be.
I put it this way yesterday on Twitter.
My hope is the middle classes are flush enough with cash – in part via government – that they have the wherewithal to take the baton (from government) and run with it.
My fear is the disinflationary forces are also big-time weights on growth
— Edward Harrison (@edwardnh) May 18, 2021
Government transfers have held things up. But there is more heavy lifting to do before households can take the baton and run with it at full speed. The risk right now is that policy makers, especially Republican partisans looking to hurt Biden, fail to recognize the precarity of the situation for many households. And that would crystallize the downside risk which has moved back into focus.